Factor investing terms and definitions

1136E-0714

For professional investors

FACTOR INVESTING - TERMS AND DEFINITIONS

July 2014 | FACTOR INVESTING - TERMS AND DEFINITIONS ROBECO | 39

Contact details and information

ContactFor further information on the factor-investing options available

to you, please ask your contact person or get in touch via

www.robeco.com/contact. Here you’ll find the contact details

for the Robeco offices.

Information– What are Robeco's factor-investing strategies?

Read more on this subject on www.robeco.com/factors

– Find out more about our approach to quantitative investing on

www.robeco.com/quantitative

– Two research papers on factor investing by Professors Koedijk,

Slager and Stork can be obtained from www.robeco.com/factorform

Follow us:

@Robeco

linkedin.com/company/robeco

Factor Investing Terms and DefinitionsRobeco

The terms and definitions are given in alphabetical order.

Text Marc van der Holst and Laurens Masereeuw

Editing Sef Laschek and Margret Smits

Coordination & production Laurens Masereeuw

Design Studio Robeco

Printer Drukkerij Damen

This publication has been compiled with the greatest possible care.

However, we cannot vouch for the accuracy of all the information it contains

and do not accept liability for any damage resulting from its application.

ISBN 9789080582576

Second edition

@2014 Robeco, Rotterdam. Nothing from this publication may be duplicated and/or published in whatever form without Robeco's prior written permission. Robeco reserves all intellectual property rights to this work.

Important informationRobeco Institutional Asset Management B.V. (Trade Register number 24123167) has obtained a license from the Netherlands Authority for the Financial Markets in Amsterdam.

July 2014 | FACTOR INVESTING TERMS AND DEFINITIONS ROBECO | 5

Rotterdam, June 2014

Dear Reader,

It gives me great pleasure to present to you this compilation of terms and

definitions.

We note that while the group of professional investors showing an interest

in factor investing has broadened significantly in recent years, the many

different terms used in this field can be a source of confusion, and the lack of

clear definitions tends to magnify existing ambiguities.

Robeco attaches great importance to factor investing and performs extensive

research work in this area. The company has developed a strategy of its own.

Factors represent specific segments of the market that are more attractive

than others in the long term. We use the term factor investing to describe a

conscious strategic allocation to factors.

Before starting to implement factor investing, it is essential to obtain a clear

understanding of the terms employed. We hope that our list of terms and

definitions will contribute to doing just that.

Joop Huij

Senior Researcher Robeco

Joop Huij joined Robeco in October 2007 as Senior Researcher. He has a PhD in Finance and is part-time professor in Finance at the Rotterdam School of Management. He further has an MSc in Information Technology and Economics (honors) from the Erasmus University in Rotterdam.

6 | FACTOR INVESTING TERMS AND DEFINITIONS ROBECO | July 2014

* A. Ang, W.N. Goetzmann, S.M. Schaefer. “Evaluation of Active Management of the Norwegian Government Pension Fund”, 2009.

Introduction to factor investingBefore presenting the different terms and definitions in this booklet, it

makes sense to talk about the significance of factor investing and how it

came into being.

Increasing interest in factor investingThe popularity of factor investing has increased considerably over the last

five years. More and more professional investors have started looking into

the possibilities it offers and applying it in the portfolios they manage.

Why is it attracting so much more interest now? Firstly, as a result of the

major financial crisis of 2007 - 2009. Achieving diversification was more

difficult than expected – equities, high yield bonds, hedge funds and private

equity actually proved to be closely correlated in this period. So, since then,

professional investors have given high priority to thinking in terms of criteria

such as diversification. Now that investors have obtained greater insight into

the underlying factors influencing risk and return, they are keen to construct

a more robust portfolio better designed to cope with shocks.

A second reason is that professional investors have become more critical

about the role of active management. They are willing to pay for the

portfolio manager's expertise and skills, on condition that good results are

obtained.

Factor investing is contributing to this discussion of the pros and cons of

active management. In 2009, the Norwegian Government Pension Fund

commissioned an in-depth evaluation* of its investment results. The

conclusion reached by researchers Ang, Goetzmann and Schaefer was

that the results achieved with active management could be explained by


exposure to factors. Their recommendation was to allocate specifically to

factors. Their research has resulted in a further increase in the interest in

factor investing.

Academic researchWhile the concept of factor investing is relatively new, most factors have a

background of many decades of academic research. The principal subjects

of study are outlined below.

– The Low-Volatility Anomaly was discovered several years before the Value

and Momentum effects, and just a few years after the Capital Asset

Pricing Model (CAPM) was developed. The CAPM assumes a positive

relationship between risk and return. Taking extra risk should therefore,

on average, lead to higher returns. However, the first empirical tests

showed that the link between risk and return is less strong than the

theory would suggest.

– Research performed by Haugen and Heins: ‘On the Evidence Supporting

the Existence of Risk Premiums in the Capital Market’ (1972), shows that

over the period 1929 - 1971, low-volatility equities realized extra risk-

adjusted returns. Later studies carried out by Haugen et al. reveal that

the low-volatility anomaly is a global phenomenon: it is not exclusive to

the United States, but also exists in Europe and the emerging markets.

– Fama and French included the Value and Size factors in their model to

explain equity returns, since they found that the traditional CAPM could

not explain all the returns realized, and sought a better alternative.

Instead of using the Market Risk factor, they incorporated the Value and

Size factors. Eugene Fama and Kenneth French provided an alternative

to the CAPM in their paper: ‘Common risk factors in the returns on stocks

and bonds’ (1993).


– In 1993, Jegadeesh and Titman published one of the first influential

studies on the Momentum factor: ‘Returns to Buying Winners and Selling

Losers: Implications for Stock Market Efficiency’. They discovered that the

US equities that performed best over 3 - 12 months also outperformed in

the following year. The data they used covered the period 1965 - 1989.

– Quality is one of the newest factors to be researched, and is as yet

sparsely documented. Recent research by Assness and Frazzini: 'Quality

Minus Junk' (2013), reveals that high-quality stocks provide better risk-

adjusted results.

– The research paper published by Koedijk, Slager and Stork ‘Investing

in Systematic Factor Premiums' (2013) shows that portfolios based on

factors are generally comparable or better than portfolios based on

market indices. This makes it possible to realize higher returns and to

lower the risk level. These results apply not only to equities and bonds,

but also to real estate and commodities.

The research paper: 'Factor Investing in Practice: A Trustees' Guide to

Implementation' (2014), distinguishes three methods of implementing

factor investing. In addition to the factor optimization approach (page

18), these are the risk due diligence approach (page 32) and the use of

factor tilts (page 20).


Contents

DefinitionsActive management 10

Anomaly 11

Behavioral finance 12

Capital Asset Pricing Model 13

Diversification over factors 14

Downside risk 15

Efficient (advanced) approach 16

Evidence-based investing 18

Factor optimization approach 19

Factor-tilt approach 21

Low volatility factor 22

Momentum factor 24

Monitoring factor exposure 25

Norwegian Government Pension Fund 26

Passive investing 27

Premium 28

Quality factor 29

Risk due diligence approach 30

Risk factor 31

Sharpe ratio 32

Size factor 33

Smart Beta or Alternative Beta 34

Traditional method vs factor allocation 35

Unrewarded risk 36

Value factor 37

Robeco's strategies 38

Contact details and information 39


Active management An investment strategy that does not invest according to a market-value-

weighted index. This strategy often requires regular buying and selling

transactions.

The object of active management is to achieve an improved

outperformance net of costs relative to the market.

Factor investing and active investing are closely related. If you choose to use

one or more factors, you are choosing to invest actively relative to a broad

market-weighted index.

Passive management means that investments are made in all market

segments. In contrast to factors with a positive premium, there are also

factors with a negative premium, such as high-volatility equities. The idea of

factor investing is to actively avoid these segments.


Anomaly This is a phenomenon that cannot be explained by standard theories. In

the case of investing, these are often divergences from the CAPM*, which

assumes that investors are rational and that there is a linear correlation

between risk and return.

The theory of 'behavioral finance' has since questioned the hypothesis of

investor rationality. One well-known anomaly is the low-volatility (low-vol)

anomaly. Based on the CAPM*-based theory, low-volatility equities can be

expected to realize lower returns than high-volatility equities, since rational

investors will only want to run more risk if they are rewarded for this in

the form of extra returns. In practice, however, it can be seen that risk and

return are less strongly correlated than is often thought.

Figure 1. Historical performance characteristics of US equity portfolio, July 1963 - December 2010

SourceBlitz (2012), Strategic Allocation to Premiums in the Equity Market, Journal of Index InvestingThe value of your investment may fluctuate. Results obtained in the past are no guarantee for the future.

* CAPM = Capital Asset Pricing Model, see page 13.

Market

Value

Past winners

Low vol

Growth

Past losers

High vol

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

10% 15% 20% 25% 30%

His

tori

cal e

xces

s re

turn

Historical volatility


Behavioral financeBehavioral finance studies the influence of psychology and sociology on

the behavior of investors and how this can impact the financial markets.

This is important because it helps to explain why markets are inefficient and

why factor premiums exist. Behavioral Finance assumes that investors are

not fully rational in their actions, but rather constantly allow their decisions

to be influenced by human emotions. These emotions elicit irrational

decisions, also known as biases or prejudices.

One example of this is the herding instinct: the shared tendency of investors

to want to take the same decisions at the same time. This can be explained

by the fact that investors do not want to run the risk of seeing returns on

their portfolio fall short of returns realized by others. We are all familiar with

the example of herding that occurred during the Internet bubble in the late

1990s. One of the main reasons that investors bought technology stocks at

that time was because they saw others earning money with them.

A second example is anchoring: the investors’ tendency to focus on

irrelevant information when making their investment decisions. They

prefer not to sell stocks at a price below their purchase price and so hold

on to them for too long in the hope of recouping their losses. As a result of

anchoring, stock prices tend to only gradually respond to news which is a

possible explanation for the Momentum factor.

Gaining an understanding of investor behavior through academic research

plays an important role in establishing an explanation for factors and factor

premiums and assessing the extent to which they will be sustainable in the

long term.


Capital Asset Pricing ModelThe Capital Asset Pricing Model (CAPM) is the product of a financial

investment theory that reflects the relationship between risk and expected

return. The model assumes a linear relationship.

The formula for calculating expected return is:

E(R) = Rf + ß * (E(Rm) – Rf)

E(R) expected return

Rf risk-free return

ß market risk

E(Rm) expected market return

The CAPM is used to forecast returns that can be obtained with risk-bearing

asset classes. The linear relationship means that taking extra risk will on

average lead to higher returns.

However, empirical tests performed in the early seventies* with this model

showed that the relationship between risk and return is less strong than the

theory indicates.

* The first study performed by Haugen and Heins: ‘On the Evidence Supporting the Existence of Risk Premiums in the Capital Market’ (1972), demonstrates that over the period 1929 - 1971, low-volatility equities realized extra risk-adjusted returns.


Diversification over factorsExposing the portfolio to a variety of factors improves diversification. The

aim of diversifying according to underlying factors is to make the portfolio

more robust.

Diversification using the factor approach differs from the traditional method

of distribution over asset classes such as equities, bonds and private equity,

commodities, hedge funds and regions. The latter approach doesn’t provide

insight into the underlying factors that determine the return-risk ratio of a

portfolio.

Factor investing means that we divide up a portfolio into factors with

significant expected risk and/or return differentials. Accordingly, the assets

in a factor-based portfolio are distributed over premiums such as low

volatility, size, value and momentum.


Downside risk Downside risk in financial terms is the chance of an unexpected and

undesirable event occurring that will impair the value of an investment.

As far as possible, investors will clearly wish to avoid any risk that is not

offset by a reward in the form of extra return.

It is important to note that volatility is not the same as downside risk.

Volatility in the financial markets is the degree of fluctuation in the price

of a stock or financial product such as a stock index or a currency. As price

fluctuations can be either downward or upward movements, volatility also

includes upside risk.


Efficient (advanced) approachAn investment approach that uses smart rules for stock selection and

portfolio construction. The aim of this is to increase returns and to lower

both risks and costs.

Robeco has developed an efficient approach of its own, which distinguishes

between rewarded and unrewarded risk. Clearly, we will want to avoid the

unrewarded risks.

In addition, we select not only individual factors, but also include others in

the assessment to prevent the positive effect of one factor being eradicated

by the negative effect of another.

Example: when following a pure momentum strategy, investors pick

mainly stocks with a high valuation. As a result, the Value factor will have a

negative effect on returns. However, by also taking this factor into account ,

investors can avoid paying too much for momentum stocks.

A number of things stand in the way of actually harvesting factor premiums,

and transaction costs form one of the biggest obstacles. An efficient

approach is one that limits the number of transactions.

Another aspect is to obtain effective distribution over sectors in order to

prevent excessive dependency on any one specific sector.


Ultimately, this approach will lead to much higher expected returns at

a lower level of risk. The table below shows the results of this efficient

approach using three factors relative to the market-weighted index.

Table 1. Substantial improvements: Returns 5-6% per year; Sharpe ratio 0.3 - 0.5

MSCI World Robeco

Value

Robeco

Momentum

Robeco

Low-volatility

Return over cash 2.1% 8.0% 7.9% 7.1%

Risk (volatility) 15.5% 14.7% 16.5% 10.6%

Sharpe ratio 0.14 0.54 0.48 0.67

SourceRobeco Quantitative Strategies; Blitz, Huij, Lansdorp & van Vliet (2013): 'Efficient factor investing strategies'. The random test covers the period June 1988 through December 2011. Returns are net of transaction costs. For low volatility, Conservative Equity data have in fact been used as of September 2006.


Evidence-based investing This is a form of investing that uses specific academic insights and evidence

in constructing investment portfolios.

At the request of the Norwegian Government Pension Fund, Ang,

Goetzmann and Schaefer carried out research into investment performance

realized in 2009. Interest in factor investing increased further as a result of

this study.

Robeco believes in using an academic approach based on empirical

evidence to identify and understand factor premiums. Robeco further

conducts research into the reasons why factor premiums occur. This

academic approach is also evident in the work the company performs

jointly with the academic world and by the range of papers it publishes in

academic journals.

Two research papers produced for Robeco by Professors Koedijk, Slager and

Stork are examples of this collaboration. The first research paper, ‘Investing

in Systematic Factor Premiums' provides mainly academic evidence for the

existence of factors. The second, titled ‘Factor Investing in Practice:

A Trustees' Guide to Implementation' (2014), takes a more practical

approach.

In addition, Robeco organizes public debates on factor investing in

cooperation with the academic world. Professors Gruber, Goetzmann and

Ang, for instance, have been asked to speak during such debates.

* A. Ang, W.N. Goetzmann, S.M. Schaefer: 'Evaluation of Active Management of the Norwegian Government Pension Fund', 2009.


Factor-optimization approach A method of implementation according to which a portfolio is fully

allocated to factors.

Here, traditional investment strategies are replaced entirely with the factor

approach*. Allocation takes place over the full range of asset classes.

The research paper: 'Factor Investing in Practice: A Trustees' Guide to

Implementation' (2014), distinguishes three methods of implementing

factor investing. In addition to the factor optimization approach described

here, these are the risk due diligence approach (page 32) and the use of

factor tilts (page 20).

The adjoining illustration shows a traditional portfolio with allocation to

asset classes (equities and corporate or government bonds). In the case of a

full factor approach, the portfolio is constructed with attractive factors.

* Robeco takes a balanced approach to equities that ensures diversification and exposure to the principal factor premiums, such as the so-called 1/n solution.


Figure 2. Traditional portfolio versus the factor investing approach

Traditional

Factor approach

SourceRobeco Investment Solutions 2014

Equities

Credits

Government bonds

EquitiesEquities Low Vol (1)Equities Value (2)Equities Momentum (3)

CreditsCredits Low Vol (4)Credits Value (5)Credits Momentum (6)

Government bondsGovernment bonds Short term (7)

1

23

4

5

6

7

Aandelen markt

Bedrijfsobligaties markt

Staatsobligaties markt

Aandelen marktAandelen Low Vol (1)Aandelen Value (2)Aandelen Momentum (3)

Bedrijfsobligaties marktBedrijfsobligaties Low Vol (4)Bedrijfsobligaties Value (5)Bedrijfsobligaties Momentum (6)

Staatsobligaties marktStaatsobligaties Short term (7)

1

23

4

5

6

7Equities

Credits

Government bonds

EquitiesEquities Low Vol (1)Equities Value (2)Equities Momentum (3)

CreditsCredits Low Vol (4)Credits Value (5)Credits Momentum (6)

Government bondsGovernment bonds Short term (7)

1

23

4

5

6

7

Aandelen markt

Bedrijfsobligaties markt

Staatsobligaties markt

Aandelen marktAandelen Low Vol (1)Aandelen Value (2)Aandelen Momentum (3)

Bedrijfsobligaties marktBedrijfsobligaties Low Vol (4)Bedrijfsobligaties Value (5)Bedrijfsobligaties Momentum (6)

Staatsobligaties marktStaatsobligaties Short term (7)

1

23

4

5

6

7


Factor-tilt approach

Add standalone factors

and/or

Changebenchmark(strategy) asset

Determine benchmarkportfolio; construct with asset factors

Determine what style factorsimprovereturn/risk profile

Chooseimplementationmethod

A method of implementation where part of a portfolio is invested

specifically in factor strategies.

Specific factors that may be under-represented in the 'standard' asset

allocation are added in this approach using dedicated factor strategies.

Figure 3. Factor Tilts

SourceKoedijk, Slager, Stork: 'Factor Investing in Practice: A Trustees' Guide to Implementation' (2014).

Different approaches to implementing factor investing can be distinguished,

such as the risk due diligence approach (page 32) and factor optimization

(page 18).


Low volatility factor

Low volatility

High volatility

Risk (volatility)

Ret

urn

12%

10%

8%

6%

4%

2%

0%

0% 10% 20% 30% 40% 50%

* Haugen and Heins ‘On the Evidence Supporting the Existence of Risk Premiums in the Capital Market’ (1972)

Low volatility stocks realize comparatively high risk-adjusted returns. The

same is true for corporate bonds.

The notion that greater risk pays off in the long run by generating higher

returns has been proven incorrect by academic research*. Further studies

show that the performance of low-risk stocks does not lag that of the market

as a whole. The chart below demonstrates this on the basis of data from a

study.

Figure 4. Risk-return ratio 1931 - 2009

SourcePim van Vliet: 'Low-volatility investing - a long-term perspective', January 2012.

Robeco's approach to investing in low-volatility equities is reflected in its

'Conservative Strategy'. Compared to an ordinary low-volatility strategy, this

approach strives to achieve lower transaction costs, reduced risk and extra

returns in a market upturn.


Robeco not only selects stocks on the basis of low volatility, but also looks at

insolvency risk and Value- and Momentum-driven factors. For example, by

taking the Value factor into account in the selection of low-volatility stocks,

investors are prevented from paying too high a price.

This is how this strategy differs from that used by low-vol investors who select

stocks exclusively on the basis of historically low volatility.

Figure 5. Improved risk-return ratio in Robeco's Low Volatility factor approach - Robeco Conservative Equities

SourceRobeco, Quantitative Research, 2014.

Robeco uses the low-volatility anomaly not only for stocks, but also for

bonds, and calls this approach 'Robeco Conservative Credits'. According

to this methodology, investments are made consistently in the bonds of

companies with a low level of expected risk.

These bonds are characterized by a shorter time to maturity and a higher

level of 'seniority' (the order of repayments in the event of default). The

bonds are issued by companies with relatively low debt-to-equity ratios.

Lowvolatility

Low riskfactors

Conservativeequities

Risk

Ret

urn


Momentum factor Stocks tend to maintain recent price trends in the future, and the

momentum strategy takes advantage of this phenomenon. When using

a momentum strategy, it is important to be aware of the risk of trend

reversals and of how that risk can be mitigated.

The momentum premium is one of the largest factor premiums, but it

is hard to capture because of two practical problems. First, a substantial

drawdown can occur if there is a trend break like a market reversal, as the

strategy will select equities with high market sensitivity in a bull market.

Second, the group of stocks with the strongest trends changes all the

time, causing high turnover in the portfolio. The transaction costs that this

turnover generates eat into the momentum premium.

Figure 6. Improved risk-return ratio with Robeco's Momentum factor approach


Unlike ‘traditional’ momentum based on total returns, Robeco calculates

‘residual’ momentum, adjusted for market risk in particular. This avoids the

unrewarded risks of a traditional momentum strategy. Furthermore, smart

portfolio construction rules ensure only necessary trades are done and

transaction costs are minimised.

Momentum

Market

Robeco momentum

Risk

Ret

urn


Monitoring factor exposureRobeco examines existing investment portfolios' exposure to factor

premiums using its own customized scanning system. This is known as the

'Robeco Factor Exposure Monitor'.

The scan shows the relative underweights or overweights per factor (relative

to the market portfolio). This can form a first step in the decision-making

process for implementing factor investing.

Figure 7. Relative factor exposures of portfolios


The chart shown above represents a portfolio that overweights the Value

factor while underweighting the Momentum and Low-volatility factors.

Middle BottomTop

20%

15%

10%

5%

0%

-5%

-10%

-15%

Value Momentum Low volatility


Norwegian Gov. Pension FundInterest in factor investing has increased substantially as a result of

research in 2009 into the investment results realized by the Norwegian

government oil fund.

The fund invests the revenue from oil and gas extraction for future

generations. In 2009, it commissioned a study* into the investment

performance of active management. The disappointing investment results

realized in 2008 formed the underlying rationale for this.

The conclusion from this study by Ang, Goetzmann and Schaefer was that

the results of active management could be explained by exposure to factors.

Their recommendation was to allocate specifically to factors. Interest in

factor investing increased further as a result of this study.

* A. Ang, W.N. Goetzmann, S.M. Schaefer: 'Evaluation of Active Management of the Norwegian Government Pension Fund', 2009.


Passive investing

Passive investing is following a market-weighted index without deviating

from it to achieve extra returns (alpha). Investors thus obtain the index

returns adjusted for costs.

In the case of active investing, trackers – also referred to as ETFs – are often

selected. Investors use a tracker to follow a stock or bond index.

A passive approach has advantages and disadvantages. Passive

investors enjoy low management costs and low trading activity, but this

is accompanied by a major disadvantage. Using the passive approach,

investments are also made in those segments of the market that are

characterized by an unattractive risk-return ratio. Take high-volatility

equities, for instance. In an active approach, investors can avoid these

segments and focus on the attractive parts of the market.


Premium Reward or extra return for taking risk or exposure to factors.

Factor investing is a way of earning premiums by taking exposure to factors.

Robeco wants not only to document certain statistical patterns, but also to

find the underlying explanation for these factors. The theory of behavioral

finance also provides explanations for factors.

Premiums are often explained as representing compensation for risk, and

are referred to as risk premiums. Research - some of which conducted by

Robeco - has shown that premiums are not always the result of risk-taking

(see explanation of unrewarded risks) and it is therefore better to use the

term 'factor premiums'.


Quality-factorForms part of an investment strategy that selects high-quality companies.

The criteria for this factor can be 'hard' (e.g., returns on shareholders' equity

and free cashflows), but the application of this factor can also be based on

'softer' criteria such as quality of management, corporate governance and

market position. As there is no precise fixed definition for Quality, academic

circles are debating the use of this factor.

Valuation can also play a role in the selection of Quality stocks. Therefore,

ongoing debate is questioning whether this factor differs from the Value

factor. Researchers Assness and Frazzini* define the Quality factor as

investing in the stocks of safe, profitable, expanding and well-managed

companies.

Interest in the Quality factor increased in the aftermath of auditing scandals

such as the Enron affair in 2001. Another reason for the increased interest in

the Quality factor is the possibility of achieving greater diversification.

* Clifford S. Asness, Andrea Frazzini, and Lasse H. Pedersen: 'Quality Minus Junk', 2013


Risk due diligence approach

Middle BottomTop

20%

15%

10%

5%

0%

-5%

-10%

-15%

Value Momentum Low volatility

An approach* to implementing factor investing. An analysis is made to

establish whether the current portfolio is suitably distributed over factors

and does not incorporate excessive risk. This can be done using the 'Robeco

Factor Exposure Monitor'.

The advantage of this approach is that investors obtain greater insight into

their exposure to specific factors in the portfolio. It also helps determine

whether the portfolio contains desired or undesired concentrations of

factors. It then becomes easier to assess the sensitivity of the portfolio in

specific scenarios.

The chart below shows a hypothetical portfolio of factor overweights and

underweights. Per factor the portfolio has three subdivisions into levels of

exposure: substantial (top), average (middle) and low (bottom).

Figure 8. Relative factor exposures of portfolios

Source Robeco, Quantitative Research, 2014.

* Other approaches involve using factor tilts (page 20) and a system of portfolio optimization based exclusively on factors (page 18).


Risk factor

In factor investing, the term 'factor premium' can be replaced with 'risk

factor' or 'risk premium', on the supposition that a factor premium

represents compensation for higher risk.

However, the question remains as to whether the premiums actually

represent compensation for higher risk or whether other aspects also play a

role. If the first is true, the term risk factor is appropriate. This is in line with

the belief in an efficient market, where returns and risk go hand in hand.

However, Robeco prefers the term 'factor premium', as it is not always

necessary to take more risk to earn such premiums. The most familiar

example is the low-volatility factor (low vol). While investors actually take

less risk using this factor, the returns they can expect match the market.


Sharpe ratio The Sharpe ratio describes the extent to which an investment compensates

for extra risk. This ratio is also called the risk-return ratio.

Rp – RfSharpe ratio = –––––– p

Rp asset return

Rf risk-free rate

p standard deviation (of asset return)

The higher the ratio, the higher the risk compensation an investment offers.

Investors will therefore have a preference for investments with a high Sharpe

ratio or investments that raise the entire portfolio's Sharpe ratio through

diversification.

The Sharpe ratio calculates the risk-bearing return above the risk-free return,

generally using the yield on AAA government bonds for risk-free return.


Size factorStocks with a lower market value (mid and small caps) realize higher

returns than those with a higher market value or capitalization (large

caps).

In academic circles the discussion focuses on whether the better expected

performance of companies with a lower market value is only compensation

for the higher degree of risk.

Another point of discussion concerns the transaction costs that accompany a

strategy based on this factor. These costs are higher for equities with a lower

market value due to the reduced liquidity.

Robeco implicitely uses the Size factor by including mid and small cap stocks

in its investable universe.


Smart beta or alternative betaAn index strategy that aims for a better risk-return ratio than the

traditional market-capitalization weighted index. 'Smart beta' refers to the

higher expected index performance, in terms of risk and return.

The smart-beta strategy is an alternative index strategy for investing in a

market-cap-weighted index, since the market-cap-weighted approach has a

number of constraints for investors. For instance, most of the money flows

into stocks with the highest valuation. This means that investments are

made counter to the Value factor, which focuses on selecting stocks with a

lower valuation.

Just like factor investing, smart beta strives to create an improved risk-return

ratio. An important aspect is that smart-beta strategies are not passively,

but actively managed. Examples of smart-beta strategies are equally

weighted equity strategies or low-volatility strategies.

Although smart-beta factor approaches have proven capable of using factor

premiums, there are a number of pitfalls. Taking unrewarded risk is an

example, as are taking on higher transaction costs and the negative effects

of other factors.


Traditional versus factor allocationTraditionally a portfolio is constructed by distribution over asset classes

(asset allocation), followed by allocation to subsegments such as regions or

sectors. Factor investing applies strategic allocation according to factors.

The example below illustrates this process of moving from traditional

strategic asset allocation towards strategic distribution according to factor

premiums for equities.

Traditional strategic asset allocation

Traditional allocation across regions

Strategic allocation to factor premiums


A factor portfolio divides the equities class into premiums such as low

volatility, value and momentum, irrespective of regions and sectors.

Government bonds

Credits

Equities

Government bonds

Credits

Equities US

Equities Europa

Equities Japan

Government bonds

Credits

Equities remaining

Equities High Value

Equities High Momentum

Equities Low Volatility

Figure 9.


Unrewarded risks Higher risk that is not rewarded with higher returns.

Investors should strive to avoid unrewarded risk in their selection process,

as this is not compensated for with any kind of payoff in the form of higher

returns.

An example of taking unrewarded risk is to buy cheap stocks of companies

with a higher risk of default. It may appear that these are value stocks that

enable the investor to benefit from a value premium, but our research

shows* such stocks are very risky. Investors do not benefit from the value

premium because they are not compensated for this higher level of risk with

a higher return.

* W. de Groot and J. Huij: ‘Is the Value Premium Really a Compensation for Distress Risk?’, 2011.


Value factorEquities realize better returns if their current value is higher than their

current price. A value strategy makes use of valuation ratios to select

stocks that are attractively priced relative to their fundamentals.

The price-to-book and price-earnings ratios are both frequently used. Stocks

with low prices relative to their fundamentals are expected to appreciate in

the future to properly reflect the real value of the company.

However, the pitfall here is that an increased risk of insolvency can be

the reason for a low valuation. A company that has an outdated business

model, for instance, runs a greater risk of becoming insolvent, and its stock

price will reflect this by having an apparently low valuation relative to its

book value.

Figure 10. Improved risk-return ratio with Robeco's Value factor approach


Robeco’s approach to value investing is to make stock-selection adjustments

that take a higher level of risk into account. This means that stocks that

are indeed undervalued are selected, in contrast to companies whose low

valuation merely reflects their higher level of risk.

Value

Market

Robeco value

Risk

Ret

urn

!


Robeco's strategiesRobeco applies factor investing via different strategies, such as the

Developed and Emerging Quant strategies, and also uses it for the return

portfolio of professional parties.

Robeco offers customized factor-investing solutions for (large) professional

parties. These solutions may focus on individual strategies or on a

combination of strategies, such as a 1/n solution.

In addition, Robeco has four conservative strategies for low-volatility (low

vol) investing in equities, and one for bonds. There is also a global equities

strategy that applies the Momentum factor and one that uses the Value

factor.

Conservative strategiesEquities

– Emerging

– Global

– European

– US

Bonds

– Credits

Global strategies for other factorsEquities

– Momentum

– Value

July 2014 | FACTOR INVESTING - TERMS AND DEFINITIONS ROBECO | 39

Contact details and information

ContactFor further information on the factor-investing options available

to you, please ask your contact person or get in touch via

www.robeco.com/contact. Here you’ll find the contact details

for the Robeco offices.

Information– What are Robeco's factor-investing strategies?

Read more on this subject on www.robeco.com/factors

– Find out more about our approach to quantitative investing on

www.robeco.com/quantitative

– Two research papers on factor investing by Professors Koedijk,

Slager and Stork can be obtained from www.robeco.com/factorform

Follow us:

@Robeco

linkedin.com/company/robeco

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